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Thursday, October 6, 2011

Why Didn't Dot-Com Crash Hurt Like Housing Crash Did?

In the late 1990s, the U.S. economy suffered the end of the dot-com bubble, but had only a mild recession lasting for 8 months in 2001. But when the housing bubble popped, the U.S. economy had a brutally deep 18 month recession from December 2007 to June 2009, followed by a Long Slump of a recovery. Why did the bursting of the housing bubble hurt so much more?

The answer is that when the dot-com boom collapsed, the lost value was in stock prices. Those who bought stocks knew in advance that stock prices could rise and fall. The losses for pension funds and retirement accounts were large, but they didn't cause widespread household or firm bankruptcies. However, when the housing price bubble burst, the losses were in the form of debts that couldn't be paid off. People couldn't pay their mortgages. Banks and financial institutions which were holding dicey mortgage-backed securities faced huge losses, and a financial crisis resulted. If the dot-com boom had been financed by enormous waves of household and business borrowing, and that borrowing had been turned into securities widely held by banks, then the bursting of the dot-com boom would have been much more economically destructive.

The key difference here is between equity and debt. The value of equity is contingent on what happens in the stock market, and so can rise or fall. But debt is typically not contingent on how other values change: you borrowed it, you need to pay it on schedule. Otherwise, defaults, foreclosures, bankruptcies, and financial crisis can result. Kenneth Rogoff thinks through many of these issues in the 2011 Martin Feldstein Lecture to the Natural Bureau of Economic Research: "Sovereign Debt in the Second Great Contraction: Is This Time Different?"

Rogoff focuses on this difference between non-contingent debt and contingent equity: [E]ven before the onset of the Second Great Contraction, it should have bothered macro-theorists more that such a large fraction of world capital markets consists of non-contingent debt, including public and private bonds, as well as bank credit. It is difficult to pin down global aggregates, but a recent McKinsey study found that at the end of 2008, the equity market accounted for roughly $34 trillion out of $178 trillion in global assets, with government debt, private credit, and banking accounting for the rest. This figure, of course, is exaggerated by the global stock market crash that occurred after the collapse of Lehman Brothers in 2008, but even at the pre-crisis equity level of $54 trillion, equity markets represented less than one third of the total. True, there is an entire zoology of derivative markets that makes some of the debt contingent, but incorporating these would not dramatically change the basic point."

As Rogoff points out, there have been proposals by Robert Shiller and others that when governments borrow, they should do so in a more contingent form--for example, perhaps the debt payments could adjust automatically if their GDP growth is faster or slower than expected. But in practice, given how governments can play games with their own economic statistics, such an approach has had limited appeal. In general, the clear promise to repay debt is easier to monitor and to enforce than a payment schedule linked to some other variable. But this widespread use of non-contingent debt, which in turn is subject to a wide array of poorly-understood risks, contributes to making the world economy a fragile place when bad news arises.